How Much Trust To Put In A Trust

August 19, 1985|By Mohammed Alidina, Special to The Sentinel

The rich have used them for years to shift income and avoid taxes. The clergy used them to help maintain vows of poverty. International high rollers have them to keep their anonymity. Now, middle-class Americans are becoming aware of trusts and are setting up trusts to minimize their income taxes.

With the right trust, you can avoid (or minimize) taxes by shifting income from your assets to your children, but still keep your assets. The children pay little or no tax on the income from the assets and in the end you get back your assets.

If the trusts are so good, then why hasn't the Internal Revenue Service challenged them? And is Congress, in its tax reform mood, going to put a stop to such trusts?

First, let's take a look at the features and drawbacks of the two trust arrangements, and then consider their future.

Clifford trust. Under this arrangement, you put your money (property) into a trust for a minimum of 10 years and a day. The trust invests the money and the income goes to your child for the term of the trust, and the money (property) returns to you at the end. The income on the money is taxed to your child (at a lower rate) instead of to you. Some drawbacks:

-- The income from the trust cannot be used for basic obligations of parents to support their minor children. In one instance, the Tax Court ruled that a physician, who could afford it, had a basic obligation to pay for his child's college education.

-- The time period involved in a Clifford trust is quite long. You have to tie up your money for 10 years and a day. Your child may be out of college by then.

-- The IRS already has effectively reduced the amount of money that can be put into a Clifford trust without the gift-tax exemption limits. Currently, the amounts are $16,275 for an individual and $32,500 for a married couple.

Spousal remainder trust. Under this arrangement, you put the property (money) in the trust; the child gets the income and the principal goes to your spouse at the end of the term of the trust. Because the property is being given away (in this case to your spouse), the trust does not have to last for a 10-year minimum period as required by a Clifford trust. The spousal remainder trust can be for a shorter period and thus a greater amount can be put into these trusts gift-tax-free. For example, for a married couple, a four-year trust can go up to $63,000, and a five-year trust can go to $52,750. Thus this trust's potential for tax savings are higher than for Clifford trusts.

Some potential drawbacks:

-- At the end of its term, the spouse gets the money, even in the case of a divorce. Thus a spousal remainder trust may not be a good tax planning device if a marriage is shaky.

-- The trust must be funded with individually owned assets rather than jointly owned assets.

Can these arrangements survive IRS challenges and the tax reform mood of Congress and the taxpayers?

The Clifford trust has been around for quite some time and under current law is IRS-proof. Its appeal is diminished somewhat by the lower amounts that can be put into it and the decision that financing a college education is the basic obligation of a parent who can afford it. (If a Clifford trust terminates before the child goes to college, then this problem does not arise.)

The spousal remainder trust, on the other hand, is more susceptible to IRS challenges. The tax rules for spousal remainder trusts have not been as well tried as those for Clifford trusts. The IRS may attack the spousal remainder arrangement on the ground that the person who formed the trust is effectively enjoying the benefit of the principal that has been transferred to the spouse, in which case, the trust income (and the tax on it) will be attributed to the person who formed the trust.

Will these trust arrangements fall victims to the potential tax reforms? Quite likely. The Clifford trust with its longer history is more likely to survive. However, the spousal remainder trust seems doomed. It is an arrangement that follows the form, but not the substance, of the law and is thus difficult to justify.